The 2½-year-old firm is led by Craig Packer, who ran Goldman’s leveraged loan desk; Doug Ostrover, the “O” founding partner in Blackstone Group’s credit hedge fund GSO; and Marc Lipschultz, the former head of energy investments at KKR.

They’re putting all of this talent to work in the hottest frontier in alternative asset management: direct lending.

Sure, lending is one of the oldest and most basic functions in finance. Since the financial crisis, however, investors have been pouring into direct-lending funds in waves, eager to share the profits of lending to companies either too small or too risky to be bank clients.

The direct loans carry floating rates, so enthusiasm grows with each anticipated uptick in interest rates. Direct-lending funds have returned 20.3% over the past year, according to data provider Preqin, and about 13% on average over the past three and five years. As rates have begun to climb, money has flowed in.

These aren’t the syndicated high-yield loans that investors fell in love with after the financial crisis. They’re the little sibling, not big enough to get a grade from the ratings firms.

Direct-lending deals are negotiated between lender and borrower. They’re generally smaller than bank loans, between $10 million and $250 million, and made to companies with less than $50 million—or perhaps $100 million—in earnings before interest, taxes, depreciation, and amortization, or Ebitda.

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But retail investors need to be careful: Some BDCs have been plagued by hefty fees and mismanagement in the past. Interval funds like OFI Carlyle Private Credit include other types of credit investments beyond direct lending. Or investors can buy collateralized-loan-obligation funds, or CLOs, but those buy bigger, syndicated loans.

The push into direct lending is partly a story of banks retreating in the wake of regulations passed after the financial crisis, and asset managers happily picking up the slack. For instance, interest surged in direct lending after early-2013 regulatory guidance that clarified what banks could and could not do in terms of leveraged lending.

Now, there’s more money in direct lending than there are deals. A number of factors are driving this boom. First, investors have chased floating-rate products like loans every time the threat of rising rates flares up. On top of that, many investors turned off by the market plunge of the financial crisis, and baby boomers looking at retirement, have shifted from stocks into fixed income.

As the bond market became oversaturated, investors cycled up into syndicated, rated loans—and then into unsyndicated loans.

“With any new asset class, there’s a question of where the structure of the market will ultimately shake out—there will be winners and losers,” says Andrew McCullagh, the head of origination at Hayfin Capital Management, a London-based credit platform and direct lender. While Hayfin is positive on the asset class, McCullagh cautions that risk rises in tandem with intensifying competition, peaking just before the downturn. “At this point in the cycle, one should be very focused on risk.”

That risk is the same as it always has been in any lending business: that companies will struggle to make interest payments or default, and that investors’ money will evaporate. Another worry is that in the fever of competition, investors aren’t demanding the kinds of yields and protections that would help cushion losses.

Because the loans are not registered or reported publicly, evaluating the health of the private loan market can be difficult. There are no public databases or indexes tracking returns. So it can be difficult to gauge exactly how much underwriting discipline has eroded, or to estimate the future damage—if any—that this run-up will incur.

Because of the lack of information, investors use broadly syndicated loans and, to some extent, corporate bonds as proxies for private loans. Meanwhile, the market has grown feverishly hot. Some $104.6 billion of new high-yield loans were made in May, according to Moody’s Investors Service, topping a previous record of $91.4 billion set in January 2017, and the pre-crisis high of $81.8 billion in November 2007.

Last year, fund managers raised a record $107 billion to invest in “private debt,” according to Preqin, though that term includes strategies such as distressed debt, special situations, and venture debt. Almost all of the 87 institutional investors Preqin surveyed planned to keep their allocation to private debt or increase it, over the long term.

“Too much money has flowed too quickly into the core of the private debt market,” says Stuart Fiertz, the co-founder and president of credit-focused hedge fund Cheyne Capital Management in London. “Private credit has not eliminated either the credit cycle or the economic cycle, and some investors have perhaps lost sight of that, or are becoming victims of that. Because we see a real deterioration of credit underwriting standards in the corporate-lending space.”

In direct lending, the process is simple. A company needs a loan to finance an acquisition or a leveraged buyout, or to fund expansion. The company can go to a bank, but if it wants more leverage, or looser covenants—why not?—it might prefer a private direct lender. With client money plus leverage, the lender hands money to the company. Done!

But instead of selling the debt to a wide array of yield-hungry investors, as in the high-yield bond and loan markets, private lenders generally keep it. They collect the interest payments and hope nothing goes wrong, marking the loans monthly, or even quarterly, a nice reprieve from the harsh light of intraday pricing. At the end of the loan’s life, maybe three or five years later, the lenders hopefully get their money back.

Investors love this asset class for a myriad of reasons. Direct lending helps provide diversification. Lenders have more control in a bilateral negotiation than if they are one of hundreds of debtholders. Private debt also returns money to investors faster and more regularly via interest payments, instead of price appreciation or an exit.

Most important, institutional investors project returns of about 8%, according to a recent Preqin/NXT Capital survey, at a time when the 10-year Treasury is yielding 2.8% and high-yield corporate bonds about 6%—and those rates are forecast to go higher, taking a bite out of their total returns.

Private debt has done well, too, over the past 10 years, with funds managing an internal rate of return of 8.2%, Pitchbook data show, compared with 8% for venture capital, and 9.6% for private equity.

The influx of money has shifted market dynamics so much that it has left bankers scratching their heads. Lending is a simple business, but there’s still plenty of room to muck it up.

This is where the experience and expertise of the manager come into play. Huge influxes of money attract all grades of talent, so investors must be careful in selecting a portfolio manager who knows what she is doing, particularly at this late stage in the cycle.

Banks may step back from some loans for company or deal-related reasons or simply choose not to compete with nonbank lenders when pricing or structure get too aggressive, Hayfin’s McCullagh says. “The banks are saying, ‘Be careful,’ ” he says. “You are getting higher return; you almost certainly are taking more risk. Does that mean your risk/return is improving as you’re getting those higher returns, or is it actually getting worse?”

Say that rising rates precede or coincide with an economic downturn. Suddenly, when the economy contracts, the reasons that direct lending appeared to be such a good idea—smaller companies with fewer sources of revenue and limited access to financing—could look very bad.

For example, in 2015 and 2016, when oil prices plummeted, revenues for energy-related companies slumped. That stress showed up fast in BDCs. In the aftermath, Fitch Ratings lowered the credit ratings on a spate of BDCs, including Apollo’s and Fifth Street Finance’s, citing a “notable crack in asset-quality performance.” Suddenly, there was too much exposure to one sector, too much leverage, and not enough financing options when things got dicey.

That’s not to say that direct lending faces the same fate, but anytime investors get too excited about an asset class, trouble usually follows. It’s a safe bet that direct lending is no different.

Sure, the risks may be smaller and more diffuse. These companies are ostensibly not in the same industry or geography. And defaults are forecast to stay low: In the U.S., Moody’s expects the default rate for high-yield companies to fall to 2% by the first quarter of next year, from 3.7% in May.

But the multitude of financial firms taking part, and the private market’s lack of transparency, combine for an uneasy outlook, particularly when there have been signs of standards falling in public markets.

Should it all go south, how bad might losses be?

Investors watch a metric in the rated loan market that has consistently garnered more concern: covenants, the emergency alarms triggered by credit-negative signs. When investors are eager to snap up new debt, issuers gain the negotiating advantage, and buyers are willing to surrender those protections to get the deal.

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Covenant-lite documentation—deals with no or very few covenants—has re-emerged and spread across the syndicated loan market. Now, 77.6% of all outstanding loans are “cov-lite,” according to S&P Global. While protections are tighter in the private loan market, it’s moving in step.

In the past, cov-lite meant that maintenance covenants—periodic checkups of the company’s financial temperature—were deteriorating, according to a recent note by Bank of America Merrill Lynch strategists Oleg Melentyev and Neha Khoda. Now, other, more meaningful covenants have also eroded, like those protecting against assets sales or investments. “These are key elements that will eventually determine the recoveries on loans in the next credit cycle,” they wrote.

The assumptions underpinning the broadly syndicated loan market are based on the last crisis, as GoldenTree’s Steven Tananbaum pointed out at the Milken Institute Global Conference in April. After the financial crisis, loans typically recovered 60 cents to 70 cents on the dollar. But with the influx of money bloating the asset class, loans are now more likely to recover something in the 50s, he said.

Cheyne Capital’s Fiertz agrees. “Pricing is a general downward pressure, but the covenants are really going to make the difference,” he says. “We just see this downward spiral.” He pointed to S&P Global covenant data for larger loans, saying that for smaller loans, it would be moving in a similar direction. “The fact that it is at one of its worst indications ever is a good indication of where we are.”

From his role as chairman of the Alternative Credit Council, which represents asset managers in private credit and direct lending, Fiertz has some visibility into the market via 100-plus members overseeing some $350 billion of private credit assets.

“We have all the large direct lenders in there, and every single one of them says they have not compromised on covenants yet,” he says. “Yet that’s impossible, because we account for the bulk of the market and we know, either through the surveys or larger size loans or anecdotes, that covenant quality is deteriorating.”

Photo:
Zach Meyer

There are other ways to muddy things up. Investors, for instance, are increasingly willing to accept adjusted numbers for earnings.

Some leverage ratios are based on the balance of borrowings to Ebitda. But there are ways to massage that figure. For example, in the past, a merger might be priced with the assumption that cost-savings would reach 10% of pro forma Ebitda, from day one. That assumed adjustment can now be 20% or higher, according to Rit Amin, the head of corporate and leveraged finance at Regions Securities in Charlotte, N.C. So debt-to-Ebitda ratios look much better: Something that was once six times levered can magically become just four times. Four is fine!

“That’s part of the whole structural creep we’re seeing,” Amin says. “Some of the underwriters who are less capable or not as experienced may be taking undue risk.”

With interest costs still low, companies can squeak by with those ratios. It becomes a problem when floating rates climb higher.

And there are other places to tuck more leverage. One of the primary vehicles for private loans, BDCs, had traditionally been restricted to a leverage ratio of 1:1. But after the Small Business Credit Availability Act became law in March, BDCs can increase their leverage to 2:1.

In the case of Owl Rock, it raised $5.5 billion in its main fund, Owl Rock Capital, a privately traded BDC. Owl Rock declined to comment for this article.

Firms like Owl Rock can act faster than the banks, and their size allows them to bite off bigger loans—a bit too small for a bank to corral institutional investors, but too large for most competitors. Owl Rock has invested an average of $64.5 million in each portfolio company. The firm has lent out more than $3 billion.

With more players in the market, the fight for deals has intensified. Preqin surveyed 94 private-debt fund managers last November, and 70% said they faced greater competition compared with the year before. Almost half said deal pricing was the top challenge, and sourcing deals the next most troubling thought. “Dry powder” in private debt funds—money ready to be deployed—reached a record $235 billion in March.

Still, three out of four investors told Preqin that they planned to deploy more money in the strategy this year than last.

Part of that is fueled by economic incentives: Private debt funds generally charge fees on deployed, not committed, capital, so the managers are motivated to act.

For “these many new entrants,” Cheyne Capital’s Fiertz says, “that just puts too much pressure late in the credit cycle to deploy money. How you get that deal ahead of the more established players is you undercut on quality probably more than [you] undercut on price.”

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